The $2.9 trillion municipal bond market is preparing for “hundreds and hundreds” of downgrades after Standard & Poor’s lowered the U.S. one level to AA+, the first-ever reduction for the country.

S&P is likely to cut its ratings on municipal debt secured by the federal government, such as pre-refunded bonds, tax- exempts backed by U.S. agencies, and credits that are most dependent on federal spending, Peter DeGroot, head of municipal research at JPMorgan Chase & Co. (JPM), wrote in an Aug. 5 report distributed after the federal downgrade. The New York-based ratings company said it would release a statement on state and local issuers today.

“There will be hundreds and hundreds of municipal downgrades, which will not do well to bolster investor confidence,” Matt Fabian, a managing director of Concord, Massachusetts-based Municipal Market Advisors, said in a telephone interview. “Treasuries may be able to shake off a real impact from the downgrade. Munis I’m less sure about.”

Municipal issuance has fallen amid the U.S. debt-ceiling impasse. The slump and signs of a slowing economy helped drive tax-exempt yields to the lowest this year. Scheduled debt sales total about $2.8 billion this week, the slowest August week since 2003, according to data compiled by Bloomberg.

Yields Tumble

Yields on top-rated 10-year tax-exempt debt fell to 2.4 percent last week, the lowest since October, according to BVAL data. Two-year Treasury yields touched a record low last week, then rose Aug. 5 before the S&P downgrade on government data showing the U.S. added more jobs in July than the average forecast.

The potential for downgrades to raise municipal borrowing costs comes as some states are already preparing for midyear budget cuts in the face of a weakening economy. Ohio Governor John Kasich, a Republican, told his budget director to monitor revenue collections so any emerging deficit can be averted, he said last week. Maine is also contemplating slashing its budget, the Bangor Daily News reported.

The Aug. 5 U.S. downgrade “reinforces the economic pessimism that we’ve had the last couple of weeks,” Fabian said. “It may be more difficult generally for issuers to come to market over the next couple of weeks.”

Political Process

S&P, in lowering the U.S. from AAA on Aug. 5, cited the nation’s political process and said lawmakers failed to reduce spending enough in their deal to raise the debt ceiling. Moody’s Investors Service and Fitch Ratings affirmed their top ratings on Aug. 2, the day President Barack Obama signed the bill raising the debt ceiling and avoiding a default.

Anticipated state and local government downgrades from S&P may be similar to potential ratings cuts Moody’s mapped out last month, DeGroot said in his report. Moody’s on July 13 said a possible U.S. downgrade would affect 7,000 municipal credits totaling $130 billion that are directly linked to U.S. credit.

Moody’s also said it would review indirectly linked credits and last month put five of the 15 states it grades Aaa on review for a potential downgrade because of their vulnerability to cuts in federal spending. The company wound up reaffirming those top ratings last week, assigning a negative outlook.

The aftermath of the U.S. downgrade and possible municipal rating cuts may further deter investors from buying local government debt, according to DeGroot.

Investors withdrew about $861 million from U.S. municipal- bond mutual funds in the week through Aug. 3, according to Lipper US Fund Flows. It was the second straight week of outflows and the biggest since April.

“Broader credit market uncertainty may prolong muni outflows in the near term,” DeGroot wrote in the report.